Dilution occurs when a company issues new shares of stock, resulting in a decrease of ownership for existing shareholders. Start-ups may raise capital for a variety of reasons, such as to finance growth, pay debts, or to get through tough times. Issuing new shares is less common for public companies, it's happens frequently in private markets. Therefore, when you invest in private start-ups, it's important to understand how dilution works and how it may impact your investment. 

When a start-up issue new shares, it is essentially creating new ownership in the company and diluting the ownership stake of existing shareholders. For example, let's say a company has 1 million shares of stock outstanding and you own 10,000 shares, representing a 1% ownership stake in the company (because 10,000/1m = 1%). If the company then issue an additional 500,000 shares, the total number of shares outstanding will increase to 1.5 million, and your ownership stake will now dilute to 0.67% (10,000 / 1.5 million).

So, does this mean dilution is bad?

Not always! Let's assume you invested € 10k in a start-up at a € 1m post-money, which would give you a 1% ownership stake (because 10k/1m = 1%). The company has now been growing rapidly for two years, but still see plenty of opportunity in the market for further growth. Shareholders in the company decide that to capitalize on all these promising opportunities, they want to raise EUR 1m in new capital by issuing new shares. 

Because business have progressed positively, markets now believe the company to be worth € 4m (pre-money). New investors put into the company € 1m and in return receive 20% ownership (because 1m/5m = 20%). Since new shares have been issued, your ownership stake is no longer 1% but instead 0.8% (because your stake is diluted to 4m/5m = 80% of it's original size).

So what is the part of the company you own now worth? Well, since it was valued at a € 5m post-money, your stake is now worth € 40k (because 5m * 0.8%). 

Since you initially invested € 10k in the company, this means you've made a 4x return on your initial investment! - so even though you now own a smaller piece of the pie, that pie is now a whole lot bigger, meaning you and other early investors are better off. 

There are several ways that companies can mitigate the impact of dilution on existing shareholders. One method is to offer existing shareholders the opportunity to purchase part of the new shares - and indeed, existing shareholders often have the right to do so, also known as subscription rights. If this is the case, you have the right to subscribe for your pro-rata share of the company, in this case 1% of the new shares being issued. Should you wish to do so, you then pay in an additional EUR 10k to the company (because 1% * 1m = 10k), which means that after the round you now own 1% instead of 0.8%. 

If you want to learn more about subscription rights (& other special rights usually attached to 'preferred shares'), my colleague Christopher Vail wrote a post about the topic found here.

In summary, dilution can have a significant impact on the value of an investors shares and can be mitigated through various methods, such as subscription rights. At the end of the day, dilution is part of the game of investing in private start-ups, and whether it's good or bad will depend on the performance of the company and current market conditions.